Chapter

5
Exchange Rate Derivatives

South-Western/Thomson Learning 2006

Chapter Objectives
To explain how forward contracts are used
for hedging based on anticipated
exchange rate movements; and

To explain how currency futures contracts

and currency options contracts are used
for hedging or speculation based on
anticipated exchange rate movements.

5-2

Forward Market
A forward contract is an agreement
between a firm and a commercial bank to
exchange a specified amount of a
currency at a specified exchange rate
(called the forward rate) on a specified
date in the future.

Forward contracts are often valued at $1

million or more, and are not normally used
by consumers or small firms.
5-3

Forward Market
When MNCs anticipate a future need for or
future receipt of a foreign currency, they
can set up forward contracts to lock in the
exchange rate.

The % by which the forward rate (F )

exceeds the spot rate (S ) at a given point in
time is called the forward premium (p ).
F = S (1 + p )

F exhibits a discount when p < 0.

5-4

Forward Market
Example S = $1.681/, 90-day F = $1.677/
annualized p = F S 360
S
n
= 1.677 1.681 360 = .95%
1.681
90
The forward premium (discount) usually

reflects the difference between the home

and foreign interest rates, thus preventing
arbitrage.
5-5

Forward Market
A swap transaction involves a spot
transaction along with a corresponding
forward contract that will reverse the spot
transaction.

A non-deliverable forward contract (NDF)

does not result in an actual exchange of
currencies. Instead, one party makes a net
payment to the other based on a market
exchange rate on the day of settlement.
5-6

Forward Market
An NDF can effectively hedge future
foreign currency payments or receipts:
April 1
Expect need for 100M
Chilean pesos.
Negotiate an NDF to buy
100M Chilean pesos on
Jul 1. Reference index
(closing rate quoted by
Chiles central bank) =
$.0020/peso.

July 1
Buy 100M Chilean
pesos from market.
Index = $.0023/peso
receive $30,000 from
bank due to NDF.
Index = $.0018/peso
pay $20,000 to bank.
5-7

Currency Futures Market

Currency futures contracts specify a
standard volume of a particular currency to
be exchanged on a specific settlement
date.

They are used by MNCs to hedge their

currency positions, and by speculators
who hope to capitalize on their
expectations of exchange rate movements.

5-8

Currency Futures Market

The contracts can be traded by firms or
individuals through brokers on the trading
floor of an exchange (e.g. Chicago
Mercantile Exchange), automated trading
systems (e.g. GLOBEX), or the over-thecounter market.

Brokers who fulfill orders to buy or sell

futures contracts typically charge a
commission.
5-9

Comparison of the Forward & Futures

Markets
Contract size

Forward Markets
Customized

Delivery date
Customized
Participants
Banks, brokers,
MNCs. Public MNCs. Qualified
speculation notpublic speculation
encouraged.
encouraged.
Security
Compensating
deposit
bank balances or
credit lines needed.
Clearing
Handled by
operation
individual banks
& brokers.
clearinghouse.
Daily settlements
to market prices.

Futures Markets
Standardized

Standardized
Banks, brokers,

Small security
deposit required.
Handled by
exchange

5 - 10

Comparison of the Forward & Futures

Markets
Forward Markets

Futures Markets

Worldwide
telephone
network

Central exchange
floor with worldwide
communications.

Regulation

Self-regulating

Commodity
Futures Trading
Commission,
National Futures
Association.

Liquidation

Mostly settled by
actual delivery.

Mostly settled by
offset.

Transaction
Costs

Banks bid/ask
spread.

Negotiated
brokerage fees.

Marketplace

5 - 11

Currency Futures Market

Enforced by potential arbitrage activities,
the prices of currency futures are closely
related to their corresponding forward rates
and spot rates.

Currency futures contracts are guaranteed

by the exchange clearinghouse, which in
turn minimizes its own credit risk by
imposing margin requirements on those
market participants who take a position.
5 - 12

Currency Futures Market

Speculators often sell currency futures
when they expect the underlying currency
to depreciate, and vice versa.
April 4

June 17

1. Contract to sell
500,000 pesos
@ $.09/peso
($45,000) on
June 17.

2. Buy 500,000 pesos

@ $.08/peso
($40,000) from the
spot market.
3. Sell the pesos to
fulfill contract.
Gain $5,000.
5 - 13

Currency Futures Market

MNCs may purchase currency futures to
hedge their foreign currency payables, or
sell currency futures to hedge their
receivables.
April 4

June 17

1. Expect to receive
500,000 pesos.
Contract to sell
500,000 pesos
@ $.09/peso on
June 17.

2. Receive 500,000
pesos as expected.
3. Sell the pesos at
the locked-in rate.
5 - 14

Currency Futures Market

Holders of futures contracts can close out
their positions by selling similar futures
contracts. Sellers may also close out their
positions by purchasing similar contracts.
January 10
1. Contract to
buy
A$100,000
@ $.53/A$
($53,000) on
March 19.

February 15
2. Contract to
sell
A$100,000
@ $.50/A$
($50,000) on
March 19.

March 19
3. Incurs $3000
loss from
offsetting
positions in
futures
contracts.
5 - 15

Currency Options Market

Currency options provide the right to
purchase or sell currencies at specified
prices. They are classified as calls or puts.

Standardized options are traded on

exchanges through brokers.

Customized options offered by brokerage

firms and commercial banks are traded in
the over-the-counter market.

5 - 16

Currency Call Options

A currency call option grants the holder the right
to buy a specific currency at a specific price
(called the exercise or strike price) within a
specific period of time.

A call option is

in the money
if exchange rate > strike price,
at the money
if exchange rate = strike price,
out of the money
if exchange rate < strike price.

5 - 17

Currency Call Options

Option owners can sell or exercise their
options, or let their options expire.

Call option premiums will be higher when:

(spot price strike price) is larger;

the time to expiration date is longer; and
the variability of the currency is greater.

Firms may purchase currency call options

to hedge payables, project bidding, or
target bidding.
5 - 18

Currency Call Options

Speculators may purchase call options on a
currency that they expect to appreciate.
Profit = selling (spot) price option premium
buying (strike) price
At breakeven, profit = 0.

They may also sell (write) call options on a

currency that they expect to depreciate.
Profit = option premium buying (spot) price
+ selling (strike) price
5 - 19

Currency Put Options

A currency put option grants the holder the right
to sell a specific currency at a specific price (the
strike price) within a specific period of time.

A put option is

in the money
if exchange rate < strike price,
at the money
if exchange rate = strike price,
out of the money
if exchange rate > strike price.

5 - 20

Currency Put Options

Put option premiums will be higher when:

(strike price spot rate) is larger;

the time to expiration date is longer; and
the variability of the currency is greater.

Firms may purchase currency put options

to hedge future receivables.

5 - 21

Currency Put Options

Speculators may purchase put options on
a currency that they expect to depreciate.
Profit = selling (strike) price buying price
option premium

They may also sell (write) put options on a

currency that they expect to appreciate.
Profit = option premium + selling price
buying (strike) price

5 - 22

Currency Put Options

One possible speculative strategy for
volatile currencies is to purchase both a
put option and a call option at the same
exercise price. This is called a straddle.

By purchasing both options, the

speculator may gain if the currency moves
substantially in either direction, or if it
moves in one direction followed by the
other.
5 - 23

Efficiency of
Currency Futures and Options
If foreign exchange markets are efficient,
speculation in the currency futures and
options markets should not consistently
generate abnormally large profits.

5 - 24

Currency Options Contingency Graphs

For Buyer of Call Option

For Seller of Call Option

Strike price = $1.50

Premium
= $ .02

Strike price = $1.50

Premium
= $ .02

Net Profit
per Unit

Net Profit
per Unit

+$.04

+$.04

+$.02

+$.02

0
$1.46

$.02

$.04

$1.50

$1.54
Future
Spot
Rate

Future
Spot
Rate
$1.46

$.02

$.04

$1.50

$1.54

5 - 25

Currency Options Contingency Graphs

For Buyer of Put Option

For Seller of Put Option

Strike price = $1.50

Premium
= $ .03

Strike price = $1.50

Premium
= $ .03

Net Profit
per Unit

Net Profit
per Unit

+$.04

+$.04
Future
Spot
Rate

+$.02
0
$1.46

$1.50

+$.02
0

$1.54

$1.46

$.02

$.02

$.04

$.04

$1.50

$1.54
Future
Spot
Rate
5 - 26

Conditional Currency Options

A currency option may be structured such
that the premium is conditioned on the
actual currency movement over the period
of concern.

Suppose a conditional put option on has

an exercise price of $1.70, and a trigger of
$1.74. The premium will have to be paid
only if the s value exceeds the trigger
value.
5 - 27

Conditional Currency Options

Net Amount Received

Option Type Exercise Price

basic put
$1.70
conditional put
$1.70
$1.78

Trigger
$1.74

Basic
Put

$1.76
$1.74
$1.72
$1.70

Premium
$0.02
$0.04

Conditional
Put

Conditional
Put

$1.68
$1.66
$1.66

$1.70

$1.74

$1.78

Spot
$1.82 Rate
5 - 28

Conditional Currency Options

Similarly, a conditional call option on
may specify an exercise price of $1.70,
and a trigger of $1.67. The premium will
have to be paid only if the s value falls
below the trigger value.

In both cases, the payment of the premium

is avoided conditionally at the cost of a
higher premium.

5 - 29

European Currency Options

European-style currency options are
similar to American-style options except
that they can only be exercised on the
expiration date.

For firms that purchase options to hedge

future cash flows, this loss in flexibility is
probably not an issue. Hence, if their
premiums are lower, European-style
currency options may be preferred.
5 - 30